CK22 Ltd operates in a competitive business. Demand is steadily expanding, and new plants are constantly being opened. Expected cash flows from an investment in a new plant are as follows:

Suppose that the government now changes tax depreciation to allow a 100% write-off in year 1. Existing plants must continue using the original tax depreciation schedule.

Assumptions:

• Tax depreciation is straight-line over three years.
• Pre-tax salvage value is 30 in year 3 and 60 if the asset is scrapped in year 2.
• Tax on salvage value is 40% of the difference between salvage value and depreciated investment.
• The cost of capital is 20% p.a. compounded annually.

1. What is the value of existing one-year and two-year old plants?
2. Would it make sense to scrap existing plants when they are two rather than three years old?

Year 0 1 2 3 1.Initial Investment 120 2.Revenues 110 110 110 3. Cash Operating Costs 50 50 50 4. Tax Depreciation 40 40 40 15. Income Pretax 20 20 20 16. Tax at 40% 8 8 8 17. Net Income 12 12 12 18. After tax salvage 18 19. Cash Flow 120 52 52 70 NPV at 20% $0.00